I’ve never met Bill Gates or Warren Buffet, two billionaires recommending an increase in taxes. The business owners I know aren’t demanding that their taxes be raised; they’re looking for ways to reduce them.
If your business is an S-corporation, you should know that, with proper planning, you may be able to significantly reduce the owners’ payroll tax by distinguishing between wages and distributions. Although both forms of compensation are taxable as income to the recipient, only wages are subject to the payroll tax – FICA (social security) and Medicare.
Payroll taxes are major reductions from a wage-earner’s paycheck. They are also a large expense for the employer. Employees are taxed 7.65% of gross earnings; employers must match this amount. Self-employed persons pay both the employee and employer’s share of the tax, a whopping 15.3% of their wages up to $106,800. For a business owner earning $100,000, payroll taxes cost $15,300!
In December 2010, the United States District Court for the Southern District of Iowa heard the case of David E. Watson vs. United States. 714 F. Supp. 2d 954 – Dist. Court, SD Iowa, 2010. Watson, the sole owner of his CPA firm, paid himself a small salary and a large profit distribution. This strategy reduced his payroll tax obligation by as much as $27,000 a year. By simply calling much of his income a distribution rather than wages, he put an extra $27,000 in his pocket, money he would otherwise send to the IRS.
The tax law allows a distinction between wages and distributions in an S-corporation, but before you run out and file a Form 2553 using the tax savings for a vacation to the Bahamas, know that the IRS is on to this little trick and you’ll pay a dear price. For Mr. Watson, it meant the reclassification of several years of earnings resulting in a large payroll tax liability together with penalties and interest.
If it looks like a duck, walks like a duck, and talks like a duck, you can’t get away with calling it a chicken. The IRS will look at the economic realities of your compensation, not on the form or the labels given to the transaction, and decide whether the income is wages or distributions. If you’ve mislabeled your compensation, the IRS will reclassify it and assess additional payroll tax, and then add penalties and interest on top.
Compensation Classification
Tax planning for small business owners is an important part of the overall financial management of the company. Tax is an expense in the same way that rent and utilities are an expense. Like any expense, payroll taxes should be minimized with sound planning. So how do you plan to minimize payroll taxes on owner compensation without misclassifying wages? It starts with an understanding of how the IRS classifies compensation.
The Federal Insurance Contributions Act (“FICA”) or social security tax, imposes on every employer an excise tax equal to 7.65% of the wages paid to employees. Employees pay the same 7.65% on their wages. The term “wages” is defined as all moneys paid in exchange for services provided. Employers and employees are not obligated to pay the tax on other types of compensation such as distributions of profits.
When a taxpayer disputes the IRS’s reclassification of earnings, the law presumes that the IRS is correct. The burden is on the taxpayer to prove them wrong. The IRS requires an employer to pay employees a “reasonable compensation” for their services. When an owner does ordinary work for his company, the IRS considers her an employee for wage classification purposes. Owners of S-corporations have an incentive to classify their compensation as distributions to avoid the payroll tax. But this “reasonable compensation for services performed” standard is used by the IRS to reclassify those distributions and assess payroll taxes, penalties, and interest.
An example may help clarify the distinction. The owner-operator of a construction company spends several hours a day working in his company. He performs tasks such as managing projects, paying bills, talking with customers, and generating bids. These are the activities of an employee for which the owner must pay himself a reasonable wage.
In addition to the owner, the company has other employees and hires subcontractors. The company earns a profit when the cost of employees and subcontractors is less than the price charged to the customer for their services. That profit is later distributed to the owner as a dividend, not as a wage, since this money was not derived from services the owner performed.
In a dispute involving classification of compensation, courts look at the evidence and all of the circumstances to determine whether the payment was “remuneration for services performed.” They’ll start with the company’s classification, dividends for instance, but will also look at 1) the employee’s qualifications; 2) the nature, extent, and scope of the employee’s work; 3) the size and complexity of the business; 4) a comparison of salaries paid with the gross income and the net income; 5) the prevailing general economic conditions; 6) comparison of salaries with distributions to stockholders; 7) the prevailing rates of compensation for comparable positions in comparable concerns; 8) the salary policy of the taxpayer as to all employees; and 9) in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.
Conclusion
For owner/operators of Subchapter S corporations, proper tax planning can save the company and the owner thousands of dollars in taxes every year. If you are one of those owners, make certain that you talk with your tax advisor about the classification of your compensation.
